Andrew Fleming | Deputy Head of Australian Equities | Schroders
As Australian bond yields tumble below 1.5%, the equity market harmonises. Yield is well bid; “defensives”, or at least those with earnings certainty through the near term, are trading in sympatico with bonds, at multiples hitherto unseen. The other side of the barbell is growth, or the promise of growth, which has now rerated to a level unseen for decades, since the heady days of the tech bubble in 1999 and early 2000.
The reach for yield is exemplified by the performance of the REIT sector, led by Dexus (+26%) and Goodman Group (+36%) through the past year. Ten years ago, as JP Morgan has noted, listed REITs in Australia raised $12.5b in fresh equity, and the following year another $3b was raised. Since then, no more than $1.5b net has been raised in any year, and some years have seen more buyback activity than issuance. Five months in and year to date more than $2b has been raised, with an enthusiastic audience for the equity offer mostly raised to acquire office property, and the yield offered on acquisitions is telling. Dexus, for example, acquired the remaining 50% of the MLC Centre in Sydney it did not own for $800m in March, at a cap rate of less than 5%, and hence a cash yield, being after maintenance capex, of closer to 3.5%. Dexus is not alone in seeking exposure to office property in Australia, especially Sydney, currently. Other office and industrial assets are being traded at similar multiples. Investors are bidding aggressively for equity being raised to finance these transactions.
And yet, at the other end of the ASX listed property spectrum, sits Unibail Rodamco, which has fallen through the past year by a similar magnitude to the rise enjoyed by Dexus and Goodman Group. It’s easy to say that in a yield compressed world, defensive assets are well sought and repriced accordingly. It is true; except when earnings start to go the wrong way, however modestly. As Unibail exemplifies; a 5% fall in earnings for the year to December 2019, even with a modest increase in forecast thereafter, has seen a 30% fall in equity value. Plenty of retail property assets in the Australian market are for sale, and even at much lower multiples than that being commanded by their sexy cousins in office and industrial property, buyers are hard to find.
Very few sectors don’t experience price and earnings cycles. Property certainly does. As our analyst Daniel Peters has highlighted, CBD office rentals throughout Australia over the past 30 years have shown no real growth and have seen wide cyclical swings, just like commodities. In every major capital city through this time, cyclical falls of almost 70% have been experienced from peak prices for rents. The only capital city showing real growth as a market is Sydney; and even then this has only emerged in the past two years as a confluence of exceptional factors has seen supply withdrawn (to allow for the construction of Metro stations and the repurposing of a couple of major towers) in conjunction with strong demand growth, led ironically by the major banks (which keep talking to staff reductions). Within two years, a significant amount of redevelopment will have been completed and supply of space hence become available; it may be that at that time, the cyclical forces that have historically characterised this market again dominate pricing. Two years away, though, is an eternity in a market where the most important factor right now is to try and avoid next month’s downgrade, especially when the contractual nature of lease terms for property means that the economic impact of violent price moves is deferred in any event until the lease expiry, and hence the grace period from price declines will be even longer for property equity owners. This consolation is a piffling one, alas, when a multiple in excess of 30 times earnings is being paid upfront.
Growth is the other side of the market barbell. The so called WAAX stocks, the technology darlings of the ASX, have had a magnificent six months of performance. Make that three years, such that their market caps are at absolutely high levels by any measure. All of Altium ($4.5b market cap), Appen ($3.1b), Afterpay ($5.7b), Wisetech ($7.1b), have been between three and nine baggers in the past two years, and together today represent a market cap equivalent to Brambles ($20b; which makes $1b EBIT), and IAG ($18.1b; which makes $1.3b pre-tax profit) but significantly larger than South32 ($16b; which makes $1.5b in EBIT) and Santos ($14b; which makes $1.3b in EBIT). In contrast, for the $20b in combined market stocks for the WAAX stocks, EBIT is forecast to be less than $200m this year, and cashflow will be far less.
Notwithstanding the stretched starting multiple, there is a good argument that the WAAX stocks are classic growth stocks, that will make higher future returns and for an extended period. It is possible, albeit this cannot escape the requirement to value that future growth by placing a multiple upon those expectations today. A good parable for the investment error that can arise in such situations is the experience of Computershare shareholders that acquired shares in the company during November, 1999, at $9.10 per share (in current terms). The share price was lower than this in July, 2016; almost 17 years later, even though the business had grown its earnings (1999 net profit after tax was $38m) almost 10 fold through that period. Many of the WAAX stocks today, co-incidentally, make a profit which is close to what Computershare did in 1999; if they too, grow their profits ten fold by 2036, would you expect their share prices to remain at current levels? We are not looking to cherry pick by using Computershare as an illustrative example; any other market darling technology stock listed on the ASX in 1999 or 2000 will have produced results for shareholders which are vastly inferior to the Computershare experience. Sometimes, even gold medals aren’t worth the price paid for them.
Finally, Computershare is an example of a company which grew its profits aggressively between late 1999 and now. Funnily enough, even as its share price corrected, profit growth was still strong (doubling into F2000, for example). The current market dynamic is a little different. Any downgrade is met with an immediate and solid market cap whack; of at least the downgrade, and no matter the relative recent appeal of the company and/or sector. Shareholders in all of Costa Group (-32%), Reliance Worldwide (-26%), Nufarm (-23%), Bluescope (-23%), Link Administration (-23%), Mayne Pharma Group (-23%), Bellamys Australia (-22%) and Technology One (-20%) all saw the value of their equity drop more than 20% during May, and in each case bar Nufarm, earnings were downgraded (Nufarm’s had been downgraded not long before that). Several of these stocks had in recent years been equity market darlings; the fall from hero to zero can be brutal.
Toto, we are not in Kansas anymore. Low to no interest rates are causing large dislocations in the price of Australian equities perceived to offer security of income, on the one hand, and growth on the other, with a squeeze in the ugly centre where a downgrade pimple in a flash is priced as a de-rated mole, no matter the sector. Sustainability of earnings and, more importantly, cashflows, has never been more important, nor securities more harshly dealt with if expected levels of cashflow evaporates. The better opportunities that exist in the current market tend to be idiosyncratic, where cashflows are hit albeit not by structural factors, and where derated multiples become attractive. Ensuring as best as is possible that such dislocations are transient, rather than structural, remains critical, as indeed has ever been the case.
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